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Wednesday, October 26, 2011

The First Step to Getting Out of Debt is Figuring Out How You Got In

Most people want quick, painless solutions to getting out of debt. They don't exist. The first, and hardest step is to figure out how you got into debt in the first place.

Note: This is a re-posting of an older post. While reading the Die Broke book by Stephen Pollan, I was struck by a comment he made that people shouldn't agonize about how they got into debt, but instead formulate a plan to get out. I disagree wholeheartedly. The first step to getting out of debt - and staying out - is understanding how you got there in the first place.

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Many, if not most Americans get into debt trouble at one time or another in their lives. And in many cases, this debt trouble can be crippling - leading to years of penury or bankruptcy. And the sad thing is, in many cases, these problems can be avoided, or at least attenuated.

For some, getting into debt is not something they did of their own volition. Staggering medical debts are the number one cause of bankruptcy in the United States, although in most cases, people who end up in this situation are folks who don't obtain health care coverage, for one reason or another. For some, this is because health care coverage, even a high-deductible policy is "unaffordable". For others, it is because they choose to spend their money on other things (e.g., Cable TeeVee) than health care.

But for a whole lot of others, their path to debt was paved with car payments, credit card charges, and basic living-beyond-their-means lifestyle choices.

In order to get out of debt, you have to figure out how you got into it in the first place. It is like getting lost in your car, you have to re-trace your steps to figure out how you got to where you are, and then work your way back. And no, paying someone for directions for a "short cut" like Clark Griswold did, isn't the answer.

You see, if you don't understand where you money is going and why, you cannot even begin to chisel away at the mountain of debt in your life. You may make good faith attempts to "pay down" you debts, but if your spending habits remain the same, well, nothing is going to change.

Many folks end up with staggering credit card debts over time not from one large purchase, but from years of cumulative small purchases. And since they don't see this as "extravagant living" they fail to understand why they are broke. Instead of comparing their lifestyle to their income, they compare their lifestyle to their neighbor's lifestyle, and fail to understand why they are broke. Here's a hint: Your neighbor is broke, too.

In a typical scenario, a young person gets a credit card, perhaps in college, thinking he is "lucky" to get one and that having a card is the final stage of adulthood (after owning a car, drinking, and having sex). The credit card companies have done their work well here, getting a consumer to dance to their tune, praying to the almighty credit score and getting a young person to sign up for credit on onerous terms.

Most young people have credit cards with very high interest rates, because they have no credit or poor credit. And many young people are snookered into high rate cards that are affiliated with their school, or provide airline miles, or provide status ("Gold", "Platinum" or "Diamond" cards). So they fail to think about the 15-25% interest rates on the card.

For the first few years, it all goes well. And that is the first problem right there. When you get into credit card debt problems, it occurs over time. You don't get a credit card and then declare bankruptcy the next day. It is more of an insidious, slow-motion infection that brings you down a little bit at a time. Our young consumer uses the card, and maybe even pays off the balance every month, at least initially.

But a month goes by and suddenly, he realizes that he spent far too much and cannot pay it off. It may have been an "emergency" repair for his car, or just over-spending at the mall, or playing Mr. Big-shot and picking up the check when drunk with his friends. Whatever the case, he can't make the full payment, so interest charges are applied to the balance the next month. And he is not alarmed. After all, he'll just spend less the next month and then pay it off - lesson learned, right?

But no lesson is learned, other than the interest charges ($25) didn't seem all that bad. So another month goes by and even less is paid off this time. With each passing month, the consumer pays less and less on his card. Eventually, he will be barely able to pay the minimum payment, but that could be years down the road.

As he gets older, he adds more spending to the card. Wireless phone charges or utility bills are automatically debited from his credit card account - for convenience. By putting these types of charges on "plastic" the consumer fails to realize how much they are taking out of his income. And besides, all his friends have an unlimited texting plan, right?

A first crises may occur when a monthly credit card bill is not paid. The company jacks the rate to the default 25-30% and suddenly, it is very hard indeed to make that minimum payment. A friendly offer from a competing credit card company to "roll over" a high interest balance for a low, low introductory rate (good for six months) comes in the mail, and this seems like a good way out for our consumer friend. So he "pays off" the first card with the rollover to the second. But he keeps the first card, "just in case" and because it is an ego rush to have TWO credit cards, right?

And you guessed it, he starts spending on both cards now, and runs up the balances, over time, until his debt load is twice as bad. He gets a job and gets married and he and his spouse buy a home. The debt doesn't concern him as he is making more and more money, and he figures as his income rises, he will "outgrow" the debt. But the debt is rising faster than his income is, particularly now that he is married and his wife has her own set of credit cards and bad spending habits. Neither of them has a budget or a financial plan, and not surprisingly, they argue about money - a lot.

In a rising Real Estate market, the answer to their problems seems clear - refinance their townhouse and "take out" equity to pay off the high interest rate credit cards. For only about $5000 in fees, they take out $30,000 of equity in their home and pay off the credit cards, congratulating themselves on their financial acumen. But nothing has really changed, in terms of their spending habits, which are outstripping their income by 5-10% a year. Not much, but any spending beyond your income level means only one thing - snowballing debt.

And now that they are out of debt (or so they think, all they have done is rearrange their debts) they incur yet more by spending on their now paid-off credit cards. And the process is prolonged for another five years - perhaps a decade.

Most of this spending is on small, crappy consumer items - electronics, cloths, backyard and home improvement junk. Lowes, Home Depot, Best Buy, Marshalls, and all the "big box" stores. They are getting such fantastic "bargains" - how can they go wrong?

But the debts increase yet again, until the credit cards are near their max limits and once again they are struggling with paying the minimum payments. This process could repeat itself, again and again, with more refinances and more taking out equity to pay off debt. Or perhaps the couple come into an inheritance or other lump sum, and instead of investing it for the future, pay off their old debts for McDonald's food they ate five years ago and wipe the slate clean and then start spending again.

And of course, they are spending in other areas as well - leased cars, or buying brand new cars in succession, one after another, spending hundreds of dollars a month in car payments and insurance. The monthly paycheck is divvied up among lenders, and so long as they can make the minimum payments, they congratulate themselves that they are "living within their means" when in fact a mountain of debt is accumulating like a ticking time bomb.

But eventually, the piper has to be paid. And either they run these debts up until they retire, or some other intervening even causes a crises in their lives that triggers a personal financial meltdown. A layoff from work, for example, or an illness. For many, the recent recession was it.

Suddenly, the townhouse is not worth what it is mortgaged for, and maybe one spouse loses a job. The steady income stream to keep the debt-engine running is cut off, and there is no "equity" in the home to borrow against.

Too late, they realize that their lifestyle was illusory - that they never really owned anything, and were not getting "richer" but just spending more. And once they are in this situation, it is VERY VERY HARD to get out.

The first step is to start living within your means - and that means spending less than you make. Easy to say, hard to do. Keeping track of your bank balances and credit card balances should tell you right off if you are living within your means. If your debt load increases over time, you are living beyond your means, by definition.

And yet many people in the middle class do not look at an increasing debt load with any alarm. Their car payments go up because they buy a nicer car, because they can "afford" it - and they don't think about the fact that their overall debt load is increasing in the car department, every time they trade-in. The idea of actually owning a car, outright, is alien to them. So long as they can make all the debt payments, they think they are doing OK - not thinking about the end game in all of this.

As you get older, your debt load should DECREASE over time, not increase. You will, eventually, have to pay off all these debts - the cars, the credit cards, even the house. If you keep "trading up" houses and cars and keep ratcheting up your credit card debt, you will end up with lots of shiny things, but no real wealth at all.

The second step is to work out a budget - This is also very hard to do, but essential. You have to figure out how much you are spending on food, clothes, utilities, housing, cars, etc., and then figure out what you can really afford to be spending. And you may realize that you are squandering a lot of money on silly things, when you could be living a better life instead.

Figuring out a budget is hard to do, but if you can track your expenses, you can figure out what it is you ARE spending money on, which is a good start.

Thus, the third step is to track your spending - and this means everything, down to "petty cash" things you buy with pocket change. This is also hard to do, but with accounting software, computers, and debit cards, it is easy to log in once a day and enter all your transactions and classify them as well.

This sounds hard, but is actually very easy to do. Once you get in the habit of logging into your bank and credit card accounts every day and then entering all your data, you will become addicted - it is like a video game or Farmville, only this time, when you win, you win big.

The Fourth Step is to figure out how to pay off the debt - only once you can get your spending to be LESS than your income can you realistically get out of debt. Until you do steps 1-3 above, you will continue to spin your wheels, trying to use "best efforts" to get out of debt and just sinking further and further in.

Once you start spending less than you make, you will have excess cash to pay off debts and to save money. But it is hard to do. You may have to sell off a lot of toys and junk, downsize your lifestyle considerably, and live more modestly.

When you have to live on your own income, you may be shocked to discover that you are actually poor - or not as wealthy as you thought. And compounding this is the fact that a big chunk of your income is paying off the interest and principal on debts you accumulated early in life - back when you were laboring under the illusion you were rich.

It is harsh advice, I know, but reality is harsh and that's all there is to it. I see pleas and cries on various sites from folks who say they are helplessly in debt and can't figure out how to get out of debt. And they never will get out of debt until they sit down and really examine how they got into debt in the first place. Just a few dollars a year in debt, added, compounded, and multiplied over time will snowball into a mountain of soul-sapping and life-draining debt.